Explain, in your own words, when and how the composition of capital (the mix of debt and equity) does not affect the value of the firm (i.e. the total value of debt and equity to creditors and...

Long Island University - Southampton College

1
Explain, in your own words, whenand howthe composition of capital (the mix of debt and equity)
does not affect the value of the firm (i.e. the total value of debt and equity to creditors and
shareholders).

Solution:

The capital structure of an firm usually comprise equity capital and debts. The objective of optimal
capital structure is to minimize the overall capital cost of the firm and thereby increase in its value. The
weighted average cost of capital (WACC) of a firm is given as –

WACC = {Cost of equity (Ke) X Weighted of equity (We)} + {Cost of debts (Kd) X Weight of Debts (Wd)}

Value of a firm is given as-
Value of a firm = Value of Equity + Value of Debts
Given the same amount of earnings for equity the value of equity rises when the cost of equity
decreases. Similarly, for a given amount of earnings, the value of debts increases when the cost of debts
decreases. In nut shell, the value of firm would rise, if the overall WACC decrease and vice versa.
Franco Modigliani and Merton Millar (MM) produced capital structure irrelevance theory. They argued
that the capital structure of firm does not affect its value. For this, following assumptions were made:
1. There is not taxation.
2. All investors have same expectation of earnings from firm.
3. There is no transaction cost.
4. The capital market for Debt and Equity are perfect.

The equity holders of the firm bears higher risk than the debts-holders and hence require higher rate of
return. In other word, the cost of equity usually remains higher than the cost of debts.
Suppose a firm has 50% equity and 50% debts in its capital and cost of equity of equity and debts are
10% and 8% respectively. So the WACC is 9% and say the value of firm is $ 10,000.
Now, the firm increase debts to 60% of total capital and reduce its equity weight to 40%. The increase in
debts would increase the leverage and the resulting financial risk for the equity holders. Therefore, the
equity holders would ask higher rate of return for the higher financial risk. Consequently, the cost of
equity would go up to say 10.5% and the overall WACC of firm would still be 9% { .60 X .08 + .40 X
0.105}. Given the same earnings from firm, the value of firm would remain same due to same WACC.
Hence, if the given assumptions hold, the value of firm will not change due to change in capital
structure. The value of firm would change only for change in total earnings.

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